Value Funds Falter in Race With Growth

Is “value” style investing still in charge on Wall Street?

Value-oriented stock mutual funds are en route to their third straight calendar year of superior performance compared with “growth” funds. But value’s margin of leadership has thinned in a stock market where almost nothing seems to work.

Large-cap value funds fell 18.3% in the third quarter, on average, leaving the category down 25% for the year, according to data from Morningstar Inc.

By contrast, large-cap growth funds are down 30.9% for the year after an average loss of 15.8% in the third quarter.

Small-cap value funds, once a haven from the bear market, are down 15.5% for the year, on average. That’s still far better than the 31.4% average loss for small-cap growth funds, but the two categories suffered nearly equal losses in the third quarter.

Growth funds typically focus on stocks of companies whose sales and earnings are expected to grow at a faster pace than the average company’s over the long run. That includes many technology firms.

Value funds, on the other hand, try to follow the “buy low, sell high” maxim, favoring shares that offer some element of value--a below-average price-to-earnings ratio, for example, or an above-average dividend yield.

But these days, with the crash in many growth stocks, it can be hard to tell growth from value using measures such as P/Es.

The gap in average P/Es between growth and value stocks, which peaked in June 2000 at the end of the bull market, has narrowed substantially, said Daniel Seitz, senior analyst at Instinet Research in New York. With the gap now smaller than usual, the downside for growth stocks may be limited even if they are not ready to recover as a group, he said.

Other analysts argue that the shaky global economy could continue to work against growth stocks, just as an improving economy fueled their dominance from 1998 through early 2000, before the pendulum swung sharply to value when the technology bubble burst and the economy began to careen toward recession.

Growth-stock critics also say that even with the technology-heavy Nasdaq composite index down more than 77% from its 2000 peak, the growth sector may not be sufficiently washed out. On many stocks, P/Es still are higher than usual for a bear market bottom.

For long-term investors, however, there may be buying opportunities these days among downtrodden growth funds, many Wall Street pros say.

If investors learned anything from the last few years, they say, it should be that markets are cyclical. The time to buy growth funds such as Harbor Capital Appreciation or Turner Midcap Growth, growth-stock fans say, is when they’re out of favor, not when they’re flying high. Those two funds--down 32.9% and 37.1%, respectively, in the first three quarters--clearly are out of favor.

Regardless of where the market is headed, many financial advisors say the hard-to-read economy shows why it makes sense to hold a mix of growth and value funds rather than make a bold bet one way or the other.

“It’s pretty difficult to get that timing down,” said Mark Mallon, who recently was appointed chief investment officer at American Century, the Kansas City, Mo.-based mutual fund company. “That’s why we would advise people that it always makes sense to have some eggs in each basket.”

Over the long haul, growth and value styles have performed roughly equally, analysts say.

Though data now show value with bigger gains historically, either sector’s performance can be skewed “when you stop the clock” after a particularly good, or bad, run of a few years, Mallon said.

A recent survey by American Century found that although most investors don’t firmly grasp the differences between growth and value stocks, 68% understand that diversifying across both styles helps to stabilize a portfolio over time.

Still, some say there may be a good old-fashioned reason for patient investors to now tilt portfolios slightly toward growth: It’s the most out of favor.

“I might skew a little toward growth right now, but that doesn’t mean I expect it to take off tomorrow,” said Phil Edwards, chief fund analyst at Standard & Poor’s in New York.

Edwards said Harbor Capital Appreciation, Turner Midcap Growth and ABN AMRO/Veredus Aggressive Growth (which lost 42% in the first three quarters) are examples of growth funds with decent long-term records that might fare well if and when the economy looks like it’s in a sustained recovery. In 1999, as the market roared, those funds gained 46%, 126% and 113%, respectively.

When the economy rebounds decisively, growth funds would seem to be the natural beneficiaries, Edwards said. Harbor Capital Appreciation showed a glimpse of that potential during the market’s short-lived rally in the fourth quarter of 2001, zooming 25.9%, he said.

Still, analysts urge investors to proceed with caution whichever way they lean.

“The worldwide and domestic economies are so soft, I have a hard time making the case that growth runs away from value at this point,” said Don Cassidy, senior analyst at fund tracker Lipper Inc. in Denver.

One of the biggest problems for the market in recent weeks has been the spate of corporate earnings warnings, dashing hopes for a profit resurgence.

Some are more emphatically anti-growth. “In short, your children will curse the day you became a growth investor,” wrote Richard Young, editor of the newsletter Young’s Intelligence Report, in a recent article, “The Case Against Growth Stocks.”

Young noted that the Dow Jones industrials, “the Nasdaq of the 1920s,” sank 89% before bottoming out, and that Japan’s Nikkei index, “the Nasdaq of the 1980s,” has languished for more than a decade and recently hit a 19-year low.

“The only law of growth stocks is that they thrive in a condition of certainty and optimism,” Young wrote. “After all, would you have taken a chance on Cisco [Systems] or AOL at the height of their valuations in the late 1990s if the economy were in doubt, or Wall Street and corporate America showed they couldn’t be trusted?”

Mallon said his best guess is that growth and value stocks may alternate in leadership over the next few years. “This year it’s more a story of where we are in the economic recovery,” he said. “Is the economy going to recover or fall back into a ‘double dip’ recession? It’s a difficult question.”

Growth stocks could get a bounce soon from being “oversold,” Mallon said, but that could be based more on technical market chart patterns than company fundamentals.

“In the very short term, it wouldn’t surprise us if growth had a little run versus value. Over the next couple of years value could regain the edge, then maybe they’d move onto similar footing. If we got back into an expansion in the economy, then growth could assert itself later in the cycle. That would be a fairly typical pattern.”